Vertical Integration

Yesterday's Senate hearing provided some fascinating insights, not only on the energy industry but in how our government processes work. Other than two Senators who used the occasion to attempt to embarrass the executives into supporting a specific proposal, or badger them into appearing to support something detrimental to the industry, most of the questions were thoughtful, appropriate, and stimulating--even if they didn't cover all the issues I highlighted in yesterday's posting. I'd like to focus on a question from Senator Gordon Smith of Oregon. He asked about the impact of vertical integration on high prices and industry profitability. I'm not sure he got a clear answer, or at least one that would adequately explain to the public what vertical integration in the energy industry really means today, which is quite different from what it used to mean.

When I filled up my first car at Shell stations in the mid-1970s, the gasoline I put into it almost certainly came from a Shell refinery, processing crude oil produced from Shell's oil wells and transported in a Shell tanker or pipeline. That's what we normally think of when we talk about "integrated oil companies." But however true that picture was then, it no longer reflects the way the industry actually operates. Today, while these companies still participate in the most important elements of the industry's "value chain"--the connected business segments that hand off the commodity to the next segment in line, and finally sell it to consumers--that participation is increasingly through relationships other than direct ownership of the commodity at every stage.

First, let's look at crude oil. After the wave of nationalizations in the 1970s, much of the oil previously "owned" by the international companies became the property of state enterprises such as Saudi Aramco, Petroleos de Venezuela, Pertamina, and others. The major oil companies had to rebuild their portfolios, typically on terms that involved higher royalties, taxes, and sometimes even profit caps. As production from their US oil reserves declined over the last three decades, while demand increased, most of them became increasingly reliant on third party suppliers of crude oil. Exxon, for example, produces less than half the oil they refine globally, and that doesn't factor in any production sold to third parties, due to location or quality.

The refining business has changed significantly, too. We heard a great deal yesterday about the lack of new refinery construction in the US, but little about the vast restructuring of the industry in the 1980s and 1990s, when many small refineries were shut down, and many others were sold by the majors to independents such as Valero, today's number one US refiner. This change has put most of the majors in the position of buying refined products from either independent US refiners or offshore facilities, in order to supply their domestic markets. Chevron's refineries cover only half the company's global marketing requirements.

Transportation has changed, too. Few of the companies own their own tanker fleets, and even when they do, they must supplement with chartered tankers owned by others. And while the majors still own important pipeline interests, companies such as Kinder Morgan and Berkshire Hathaway own large chunks of this critical infrastructure.

Finally, in retail marketing most of the name-brand gas stations you see are owned or operated by local businesses. Many of them don't even receive their products directly from the company, but through a distributor, who is responsible for delivery and probably maintains his own inventory.

The actual industry structure has evolved to one of "virtual integration", rather than true vertical integration, and I think this helps to explain some perplexing aspects of the current industry profitability. One of the Senators observed that it seemed odd that high crude oil prices would push up profits, when they simultaneously raise the company's cost of doing business. But when you examine this disaggregated business model, you can see how this could happen:

• High oil prices boost earnings for the Upstream, where oil is discovered and produced, on the production it owns outright, and to a lesser degree on oil for which it shares profits with foreign state oil companies.
• The refining segment pays more for its inputs, but when demand exceeds the ability to supply, refining margins go up. As a result, refining segment earnings rise, in some cases dramatically. So even for companies that experienced refinery damage or shutdowns in the aftermath of the hurricanes, the margins at their remaining facilities offset the value of lost throughput.
• Marketing sees higher costs for both third-party and company supplies--which are normally transferred at market prices--but it passes these on to dealers and distributors, and so is probably little affected.
• Retailers at the end of the chain see their costs go up, and may end up getting squeezed between their suppliers and customers. Even if they can pass along 100% of the increases, their profits may drop, since higher prices reduce the volumes they sell.

That's how a "virtually integrated" oil company can make money from each segment, even if it doesn't control 100% of its supply throughout the chain. All of these segments are run as profit centers, or as totally independent businesses, and optimize their own activities more or less without regard to the others. It's a model that has worked very well in an era of plentiful hydrocarbons and ample refining capacity. Whether it can sustain its performance in a period of scarcity and tight capacity remains to be seen.